There is a lot of turmoil facing global markets these days, but – despite a shaky May – two quarters into 2019 there is a lot to be positive about. So far this year, we have seen a great deal of drama involving the world’s two superpowers on the verge of a bare-knuckle trade war. Despite the many reasons to be pessimistic, Year-to-Date (YTD) markets have performed brilliantly: Developed Market (DM) equities are up a roaring 14.49% as measured by the MSCI EAFE index; Emerging Market (EM) equities stiffed armed 2018’s woes, up 10.76% and the MSCI World ex USA Small Cap is up an impressive 13.22%. For the Second Quarter these indices are in positive territory: the MSCI EAFE +3.97%, the MSCI Emerging Markets +0.74% and MSCI World ex USA Small Cap +1.97%. Both the YTD and Second Quarter figures have a stellar June to thank for such happy reading, as the month that just finished clawed back the devastation wreaked by May with the MSCI EAFE up 5.97%, the MSCI Emerging Markets +6.32% and MSCI World ex USA Small Cap +4.59%.
Just as 2019’s second fiscal quarter transitioned to its third, US President Donald Trump was behind the scenes at the G20 summit with his Chinese counterpart Xi Jinping banging out a shiny new trade truce. This was unveiled on July 1st and markets erupted in elation, but were brought back down to earth when everyone realized that ‘trade truce’ does not actually mean a sweeping resolution to the damaging trade dispute, nor does it end the costly tariffs both sides have enacted on the other’s goods. Moreover, Chinese tech giant Huawei remains a blacklisted company in the US and President Trump has not exactly signaled that he will back down from his desire to see his allies also eradicate Huawei technology from their borders. And yet, there were good will overtures galore, including Trump agreeing to ease restrictions on Huawei’s US technology purchases and to halt a fresh round of tariffs that would hit another $300bn of Chinese goods. President Xi responded with positive gestures of his own, promising to purchase an unspecified amount of US farm products and to resume trade talks immediately.
It seems that Trump has frightened Mexico’s President Andrés Manuel López Obrado (AMLO) into submission through the threat of quickly escalating tariffs, the new free trade deal known as the United States-Mexico-Canada Agreement (which is agreed to but not yet ratified), notwithstanding. While early June was a worrying period for markets impacted by US-Mexico trade, normality resumed when Trump called off the 5% tariff on all Mexican goods on June 8th. As a result of this spectacle, trade along the southern US borders seems stable for both countries, but one wonders what the impact may be for such blatant disregard of this free trade agreement and if it may alter the way in which other nations (chiefly China) view the value of a trade deal with the US.
June saw the US and Iran on the brink of genuine military conflict when on Thursday June 20, 2019 President Trump called off an air strike on 3 Iranian targets. It is reported that the mission was aborted at the last moment as the President was advised that the strike would cause upwards of 150 casualties, which was deemed a disproportionate response to Iran shooting down a US drone. US-Iranian tensions had already been at boiling point even since an incident in the Gulf of Oman involving two oil tankers, which the US says were victims of an Iranian mine attack, which the Islamic Republic has vehemently denied. Far from being on the mend, since then US-Iranian relations have only worsened and Iran has taken dramatic steps to put pressure on the rest of the international community to re-embrace it: on Monday July 1st Iran declared that it breached the 300-kilogram limit for low-enriched uranium that was agreed in the Iran Nuclear Deal. Iranian President Hassan Rouhani warned on July 3rd that Iran would also be increasing its enrichment capacity to above the pre-agreed limits, too, and would not comply with the agreement unless it received relief from US sanctions provided by the other signatories.
Despite President Trump increasing pressure on the Federal Reserve to slash interest rates, Chairman Jerome Powell was unperturbed and announced that he would keep rates unchanged, between 2.25% and 2.5%. Trump has been a critic of Powell on Twitter and has apparently been privately threatening to fire him for failing to lower interest rates. Trump denies this rumor and Powell says he fully intends to serve his full 4-year term as the Federal Reserve’s Chairman; moreover, the President sacking Powell would be an unprecedented action that almost certainly does not have a legal basis.
In Britain the final two candidates for Conservative Party Leader and Theresa May’s replacement as Prime Minister (PM) are Boris Johnson and Jeremy Hunt. While both candidates appear to be lusting after the highest office in Britain, the winner will inherent a government that simply does not have the Parliamentary math to resolve the most pressing topic: Brexit. Johnson – who is by far the favorite – says that, while a no deal Brexit is not ideal, he will push Britain out of the European Union (EU) on October 31st, 2019 no matter what. His rival Hunt – who campaigned for Remain in the 2016 referendum – said he would deliver Brexit but would be open to extending the deadline if a deal was nearly complete. The EU and its Parliament are essentially closed for the summer, which means that when business resumes it will be very difficult for whoever wins the leadership contest to have the required time to renegotiate a Brexit Deal; besides which, the EU has already confirmed that it was Mrs. May’s deal or no deal at all.
According to James O’Leary, our Chief Investment Officer and Senior Portfolio Manager at Henry James International Management, the trade sanctions of which President Trump has become so partial have become the greatest headwind to global markets, specifically the uncertainty it forces the US economy and its businesses and consumers to face. ‘When there is uncertainty, long-term investments are not made. This slows economic growth as investment into the future is not made and decisions are deferred,’ O’Leary says. Amongst other items, this has a significant effect on job creation and retention, which subsequently affects the consumer spending power that drives the economy. O’Leary points to two sectors that have been dealt unenviable blows by the tariff uncertainty: agriculture and technology. The former has been a victim of the US-China dispute as Beijing has dramatically reduced its purchases of soybeans and other items in response to US tariffs; the latter, namely Qualcomm and Intel, has seen it coerced to end selling computer parts to China by way of a Trump executive order.
While there is clearly much lasting damage that a prolonged trade dispute would do to the American economy, the positive news is that the sting will eventually subside as supply chains are moved away from China and to other EM economies like Vietnam, India and Myanmar. While China boasts the ability to manipulate its monetary policy in a way envied by Trump, O’Leary believes that China is in a more precarious situation than the US as once American businesses move their supply chains away from China there will be minimal incentive to move them back, even after a trade deal has been realized. ‘The problem for China,’ says O’Leary, ‘is that there is a chance that these losses will be permanent.’ He continues: ‘There is a positive for other EM countries who inherit this manufacturing as it may help increase longer-term economic growth. It is also a positive for the US in that production will have been diversified away from China.’ Despite this, O’Leary believes that President Xi will simply wait out the end of the Trump presidency to see if he can get a better deal from a less bellicose Democratic president who may well assume the keys to the White House in 2021 – as China does not suffer from the inefficiencies of party politics Xi and his party arguably have time on their side.
Despite the market anxiety of the eight-day period during which Mexico faced escalating US tariffs, both countries appear to have emerged on the other side of what could have been a fraught trading relationship. Mexican President “AMLO”came into office on the back of some bold and ambitious economic promises to his electorate; despite this, the economy over which he presides has been doing very poorly. Mexican Gross Domestic Product (GDP) shrank by 0.2% in the first quarter of 2019 from the previous three months, which was below estimates a panel of economists surveyed by Bloomberg predicted. Mexico is in dire straights and the threat of tariffs offered a layer of instability that AMLO could have done without. Consequently O’Leary believes that AMLO will do anything – within reason – to stay on Trump’s good side to avoid any future tariffs.
The industry most affected by the threat of tariffs was the automobile sector, says O’Leary, which experienced plenty of equity volatility in June. European, Japanese and even American car manufacturers have opened up factories ‘south of the border’ to take advantage of the reduced cost of doing business in Mexico. While Trump’s tariffs were almost completely political in nature and focused squarely on immigration concerns, O’Leary is fascinated by a certain hypothetical: he imagines a scenario in which tariffs were enforced, which may compel car companies to bring their factories from Mexico to within America’s borders. Such a situation, which would no doubt be brilliant for the US economy, would face Mexico with one issue with which AMLO is not currently dealing; i.e. high unemployment. Historically higher Mexican unemployment means heightened illegal migration through the US-Mexico border so one wonders which political goal is the more salient for Trump: US manufacturing and jobs or thwarting illegal immigration?
Despite the roaring headwinds caused by tariff-induced uncertainty, at Henry James International Management our unbiased and disciplined country allocation system allows us to ignore the noise and focus on the facts with which our data present us. Our research is currently bullish on France, Germany and Sweden, as well as Latin America and Asia. According to our Senior Portfolio Manager O’Leary, our quantitative stock selection process will continue to flow in this direction.
The saber-rattling between the US and Iran has caught our attention, but only in so far as it is increasing our exposure to energy stocks. ‘The combination of reduced OPEC production and restricted supply from Iran has caused the price of oil to increase,’ says O’Leary. As long as the conflict persists, the price of oil will stay up, he says. While Henry James International Management is happy to enjoy the gains from rising oil prices, we believe the downside is that expensive energy will negatively impact global economic growth and pressure on consumers and businesses.
Despite Senior Portfolio Manager O’Leary closely monitoring the Federal Reserve’s near complete about-face when it comes to their projected monetary policy, he says that Henry James International Management has not had to change its own strategy as a result; rather, our quantitative growth strategy and targeted data analysis guides us safely through ‘bumpy stock market terrain’. According to O’Leary, this remains the case even in recession: ‘We generally underperform at the initial market drop and recover after a few months as valuations normalize. The portfolio naturally moves to a more defensive posture over time in a bear market while keeping its growth bias,’ he says.
O’Leary predicts that Powell will keep interest rates flat for the rest of 2019 and probably for 2020, too. While Republicans and President Trump will be keen to see interest rates lowered to spark the economy into high gear ahead of the 2020 election, according to O’Leary to see the effects of compromising the independence of a country’s national bank one only has to look to Venezuela and Turkey. ‘There seems to be a power struggle between Trump and the Federal Reserve Board,’ says O’Leary. ‘The Federal Reserve is supposed to be set up to serve the long term interests of the USA, whereas Trump wants it to serve his interests.’ O’Leary says that in 2018 the Federal Reserve’s medium term goal was to increase interest rates steadily so that when the next recession comes, they would have some stimulus tools; i.e. lowering rates, to deal with it. However, with such unstable market conditions, mostly due to tariffs and other trade issues, Powell may have to live with the existing cushion of 2.50%. O’Leary adds: ‘If the economy remains strong there will be an upward interest rate bias to hold inflation down while maintaining orderly growth.’ However, if future rising rates cause Trump to get into a battle with Powell, the American people will become the big losers, says O’Leary. In the event that rates are maintained at 2.50% – or are even lowered – EM economies may benefit tremendously as low interest rates allow them to borrow in US dollars (USD) at a low borrowing rate. Of course, this comes with a significant risk: strong USD against a weak EM currency can cause major problems in repaying loans which can result in defaults and bankruptcies.
Regarding Brexit, O’Leary says that he sees no good solutions on the horizon. ‘Once uncertainty entered the British economy prior to Brexit our system made us reduce our exposure to the UK and it has remained underweight relative to EAFE,’ he said. The UK equities to which Henry James International Management has exposed its portfolios receive a greater portion of their revenue from outside the UK rather than being domestic orientated companies. According to O’Leary, in the short-term, the question is not whether or not Brexit is a wise move for the UK as much as it is the case that it has created raging market uncertainty with dire consequences. He said: ‘We believe the UK will underperform until there is certainty; once there is certainty, UK equities will lag until it is clear whether or not the resolution to the mess that is Brexit is determined to be good or bad for the UK economy.’ In short, we believe difficult days lie ahead for UK equities.
In summary, with half of 2019 in the books there are clearly plenty of headwinds to keep investors up at night; but such anxiety belies the many reasons for optimism, not least of which markets’ apparent ability to breeze past the geo-political turmoil that can subdue them. Moreover, we believe that our quantitative strategy for growth gives Henry James International Management the ability to perform well relative to the benchmark in all market conditions.
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